with Juha Kilponen, Bank of Finland. Journal of Economic Dynamics and Control 35(4), April 2011, p. 565-578.

The credibility problems of monetary policy are enlarged by transmission lags whenever
the welfare criterion consists of arguments with di¤ering transmission lags. If, as usually
argued, prices react to monetary policy with a longer lag than output, the discretionary bias is substantially increased under a consumer welfare maximizing policy criterion (flexible inflation targeting) in the prototype New Keynesian model. Money growth targeting
can significantly reduce the discretionary bias, but is not robust to other specifications
of welfare with higher valuation of output stability.

The time-varying natural rate of interest and output and the implied mediumterm
inflation target for the US economy are estimated over the period 1983-2005.
The estimation is conducted within the New-Keynesian framework using Bayesian
and Kalman-filter estimation techniques. With the model-consistent estimate of
the output gap, we get a small weight on the backward-looking component of the
New-Keynesian Phillips curve – similar to what is obtained in studies which use
labor share of income as a driver for inflation (e.g., Galí et al., 2001, 2003). The
turning points of the business cycle are nevertheless broadly consistent with those
of CBO/NBER. We find considerable variation in the natural rate of interest while
the inflation target has been close to 2% over the last decade.

Support from the Norwegian Financial Market Fund is gratefully acknowledged.

Methods for Robust Control

with Richard Dennis, Federal Reserve Bank of San Francisco, and Ulf Söderström, Bocconi University. Forthcoming in Journal of Economic Dynamics and Control 33 (8), August 2009, pp 1604-1616.

Robust control allows policymakers to formulate policies that guard against model
misspecification. The principal tools used to solve robust control problems are statespace
methods [see Hansen, L.P., Sargent T.J., 2008. Robustness. Princeton University
Press; Giordani, P., Söderlind, P., 2004. Solution of macromodels with Hansen–Sargent
robust policies: some extensions. Journal of Economic Dynamics and Control 28 (12),
2367–2397]. In this paper we show that the structural-form methods developed by
Dennis [2007. Optimal policy rules in rational-expectations models: new solution
algorithms. Macroeconomic Dynamics 11 (1), 31–55] to solve control problems with
rational expectations can also be applied to robust control problems, with the advantage
that they bypass the task, often onerous, of having to express the reference model in
state-space form. In addition, we show how to implement two different timing
assumptions with distinct implications for the robust policy and the economy. We apply
our methods to a New Keynesian Dynamic Stochastic General Equilibrium model and
find that robustness has important effects on policy and the economy.

We estimate the interdependence between US monetary policy and the S&P 500 using structural VAR methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative properties of a monetary policy shock found in the established literature (Christiano et al., 1999). We find great interdependence between interest rate setting and stock prices. Stock prices immediately fall by one-and-a-half percent due to a monetary policy shock that raises the federal funds rate by ten basis points. A stock price shock increasing stock prices by one percent leads to an increase in the interest rate of seven basis points.

Support from the Norwegian Financial Market Fund is gratefully acknowledged.

Robust Monetary Policy in a Small Open Economy

with Ulf Söderström, Bocconi University and CEPR. Journal of Economic Dynamics and Control 32 (10), October 2008, 3218-3252.

We study how a central bank in a small open economy should conduct monetary policy if it fears that its model is misspecified. Using a New Keynesian model of a small open economy, we solve analytically for the optimal robust policy rule and the equilibrium dynamics, and we separately analyze the consequences of central bank robustness against misspecification concerning the determination of inflation, output, and the exchange rate. We show that an increase in the preference for robustness may make the central bank respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification. We also demonstrate that the price of being robust to misspecification in the Phillips curve or the output equation comes in the form of higher output and exchange rate variability, whereas robustness against misspecification in the exchange rate equation comes at the cost of higher inflation variability.

Support from the Norwegian Financial Market Fund is gratefully acknowledged.

Inflation Targeting Rules: History-Dependent or Forward-Looking?

Economics Letters 100 (2008), p. 267-270.

This paper discusses the optimal use of inflation forecasts under inflation targeting when price
setting gives rise to a Phillips curve with both backward- and forward-looking elements
(Amato and Laubach, 2003). It is shown that the monetary policy strategy is inverted relative to private
sector pricing behavior: if private sector price setting is backward-looking, policy should be
forward-looking, and vice versa. The implications of implementation and reaction lags for the
forecasts are also considered.

Model uncertainty affects the monetary policy delegation problem. If there is
uncertainty with regards to the determination of the delegated objective variables,
the central bank will want robustness against potential model misspecifications. We
show that with plausible degree of model uncertainty, delegation of the Friedman
rule of increasing the money stock by k percent to the central bank will outperform
commitment to the social loss function (flexible inflation targeting). The reason is
that the price paid for robustness under flexible inflation targeting outweighs the
inefficiency of money growth targeting. Imperfect control of money growth does
not change this conclusion.

This paper shows that in an economy with inflation persistence, it is always welfare-improving for
the central bank that acts under discretion to assume that there is no inflation persistence. Under
reasonable assumptions about inflation persistence, all of the inefficiency associated with
discretionary policymaking is removed.

We study the effects of model uncertainty in a simple New Keynesian model
using robust control techniques. Due to the simple model structure, we are
able to find closed-form solutions for the robust control problem, analyzing both
instrument rules and targeting rules under different timing assumptions. In all
cases but one, an increased preference for robustness makes monetary policy
respond more aggressively to cost shocks but leaves the response to demand
shocks unchanged. As a consequence, inflation is less volatile and output is
more volatile than under the non-robust policy. Under one particular timing
assumption, however, increasing the preference for robustness has no effect on
the optimal targeting rule (nor on the economy).

Support from the Norwegian Financial Market Fund is gratefully acknowledged.

Targeting Inflation by Forecast Feedback Rules in Small Open Economies

Journal of Economic Dynamics and Control, 30, 2006, 393-413.

We argue that in practice, the inflation-targeting strategy can be approximated by the interest rate responding to the unchanged-interest-rate forecast of inflation. A method is developed to derived unchanged-interest-rate forecasts in forward-looking models and evaluate the performance of the policy rules in an optimizing New Keynesian model due to Monacelli (European Central Bank, Working paper Series: 227), estimated on UK data. We find tha the policy rule is less prone to generate a determinate rational expectations equilibrium if based on an unchanged interest rate compared to the rule-consistent forecast. Both rules approximate the optimal commitment rule policy if the central bank attaches sufficient weight to inflation as opposed to output gap stabilization. The optimal forecast-feedback horizon is close to a year and a half and is largely independent of how much the central bank prefers inflation to output gap stability.

Several research contributions have argued that information about the output gap is essential for a good moptimal onetary policy rule. However, as pointed out by Orphanides (2001), there is considerable real-time uncertainty about the size of the output gap. The paper argues that simple monetary policy rules that rely exclusively on (survey-based) information about future and past inflation rates may be more efficient than optimized Taylor rules once real-time output-gap uncertainty is accounted for. Even when only information about historical inflation rates is available, a very simple policy rule may be constructed that improves on the Taylor rule.

The paper argues that there are reasons to include variability in each sector
separately in the social welfare loss function, in addition
to aggregate output and inflation variability. However, we
find that an attempt by the central bank to stabilise each
sector separately in counter-productive. Thus, although sectoral
output variability may enter the true welfare loss function,
the central bank should focus on the variability of aggregate
output and inflation. The reason for this result is that the
forward-looking variables in the model, in particular the
exchange rate, produce a policy imperfection under discretion.
If the central bank were able to commit to an optimal rule,
it could exploit the exchange rate channel in a favourable
manner. In the realistic case of discretion, however, the
exchange rate channel becomes less effective compared to the
interest rate channel. The ineffective use of the exchange
rate channel under discretion results in a stabilisation bias,
where the non-traded sector is stabilised too much and the
traded sector too little. The paper also considers alternative
instrument rules and finds that a standard Taylor rule performs reasonable well compared to
the alternative rules considered.

We study simple inflation-forecast targeting in an open-economy setting. Simple inflation-forecast targeting implies setting an interest rate which, if kept unchanged throughout the forecast-targeting horizon, produces a conditional inflation forecast equal to the inflation target at the end of the horizon. We find that the optimal forecast-targeting horizon is relatively short (one year). A longer horizon does not consistently contribute to improved output stability, indeed it increases exchange rate variability and traded sector variability. The targeting procedure is substantially inferior to the optimal pre-commitment policy. Moreover, the targeting procedure does not necessarily determine the rational expectations equilibrium and is subject to time inconsistency.

A discretionary monetary policy leads to sub-optimal stabilization in models with forward-looking price setting, and various policy rules that improve the discretionary equilibrium have been considered in the literature. The empirical evidence for forward-looking price determination is, however, mixed. This note shows that policy rules that improve welfare under New Keynesian assumptions also do so within a standard backward-looking model if asset prices, such as the exchange rate, are forward-looking.

We analyze the performance and robustness of some common simple rules for monetary policy in a New-Keynesian open economy model under different assumptions about the exchange rate model. Adding the exchange rate to an optimized Taylor rule (that responds to CPI inflation) gives only small improvements in terms of economic stability in most model configurations. The Taylor rule is also slightly more robust to uncertainty about the exchange rate model than are rules that respond to the rate of exchange rate depreciation. Our results thus indicate that the Taylor rule is be sufficient to stabilize a small open economy, also under exchange rate model uncertainty.

A Game between the Fiscal and Monetary Authorities under Inflation Targeting

European Journal of Political Economy, 20(3), September 2004, p. 709-724.

A game between the fiscal and monetary policymaker is studied in an open-economy model. The central bank targets in.ation, whereas the fiscal policymaker has several objectives, including output stabilization, but cannot commit to a strategy. If a commitment to an action is also infeasible, a Nash game is played and a conflict over the appropriate size of the output gap arises. Legislative restrictions on fiscal policymaking will then improve the policy mix. This conflict is resolved if the fiscal policymaker can commit to an action and thus play the Stackelberg game, internalising its effect on monetary policy.

Targeting Inflation by Constant-Interest-Rate Forecasts

Journal of Money, Credit, and Banking 35(4), August 2003, p. 609-626.

This paper reviews the concept of constant-interest-rate inflation forecast (CIR) targeting employed by several inflation targeting central banks. It stresses the time-inconsistent nature of CIR targeting and provides a new method for constructing CIR forecasts consistently in the context of models with forward-looking variables. Using a modern dynamic aggregate demand and supply model with forward-looking price setting, the analysis suggests that the main reason for choosing a relatively long forecast targeting horizon lies in the monetary authorities' objective to smooth interest rate movements. When price setting is completely forward-looking, the performance of CIR targeting comes close to the optimal commitment policy. Targeting inflation in this way may, however, imply indeterminacy of the rational expectations equilibrium if agents do not resort to the minimum state variable selection criterion.

The note analyzes time inconsistency problems related to the exchange rate channel of monetary policy. Within a simple open-economy macroeconomic model, where the exchange rate is the only forward-looking variable, we show that a dfference between optimal policy under discretion and commitment emerges. Moreover, the nature of the time-inconsistency problem resembles that resulting from standard New Keynesian models: When supply shocks occur, the exchange rate channel gives rise to excessive output stabilization and insufficient inertia in monetary policy under a discretionary policy.

This paper analyzes alternative monetary policy regimes within a simple, estimated macroeconomic model with a traded and a non-traded sector. Two general classes of regimes are considered, inflation targeting and exchange rate targeting, where the latter also includes monetary union. Flexible inflation targeting produces lower nominal and real variability than exchange rate targeting, because the latter gives rise to persistent oscillations in the real interest rate and the real exchange rate due to the Walters’ effect. We find that concerns about sector-specific variability have no significant effects on the optimal monetary policy. In addition to the targeting rules, we also consider commitment to two types of simple instrument rules, the Taylor rule and an MCI rule. Generally, we find that these simple instrument rules perform well compared with the complex targeting rules.

Uncertainty about the Degree of Inflation Persistence: How robust is Your Monetary Policy Strategy?

The paper considers the effect of inflation persistence on discretionary optimising monetary policy targeting regimes. We find that nominal level-targeting regimes (e.g., price-level targeting) is more sensitive to different assumptions about inflation persistence than a nominal growth-targeting regime (e.g., inflation targeting). A level-targeting regimes work better when there is little persistence in inflation. A robust finding is that money growth targeting outperforms all other growth-targeting regimes irrespective of the degree of inflation persistence.

We estimate the output loss associated with deliberate disinflation – the sacrifice ratio – for
six small open economies, through the simulation of estimated VAR models where the
historical monetary policy has been identified. We estimate the sacrifice ratio before and after
the introduction of explicit inflation targeting in Canada, Sweden and the United Kingdom,
and compare estimates with similar periods for Norway, the Netherlands and Switzerland.
The sacrifice ratios decline after the introduction of inflation targeting. We interpret this as
evidence that inflation targeting has enhanced monetary policy credibility.